Few graces have been afforded through the hardships that the COVID-19 pandemic has levied among private companies here in the United States as well as the rest of the world. And for impacted companies, the thought of tackling ASC 842 implementation during the pandemic is unduly burdensome. Fortunately, in June 2020, in a rare display of compassion, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update, which provided a limited deferral on effective dates of ASC 842 adoption (ASU 2020-05). For most private companies, the effective date of ASC 842 adoption has been pushed out to January 1, 2021, for calendar year entities.
In 2016, the FASB issued ASU 2016-02 and codified as “Accounting Standards Codification: Topic 842 – Leases,” or “ASC 842.” This new standard aimed to record most leases on the balance sheet as lease liabilities and corresponding assets for the right to use leased assets (i.e., “right-of-use” or “ROU” assets). It goes without saying that ASC 842 results in a significant shift in accounting and reporting replete with volumes of technical accounting guidance and disclosure requirements. We won’t discuss many of these, as there are a multitude of publications that delve into every nook and cranny of ASC 842.
Rather, this article is for private companies who have yet to implement the new lease accounting standard who stand to benefit from pragmatic lessons learned along the way about the implementation process itself. If there can only be one takeaway from this article, it’s this: Don’t underestimate the time and resources required for ASC 842 implementation.
Many companies have overspent on human and financial resources implementing ASC 842 project plans as they were not anticipating the pervasive and labor-intensive effort required. The following highlights cogs in the ASC 842 implementation process that, in retrospect, presented unexpected challenges that could have been avoided if proper precautions and adequate planning were employed as early on in the implementation process as afforded.
Establishing Lease Population
It may sound like a straightforward process, especially with more significant real property leases, but aggregating all leases affected by ASC 842 may prove to be a daunting task. In addition to real property leases, entities can have hundreds of leased vehicles and equipment affected by ASC 842 if not already recorded on the balance sheet as capital leases. The aggregation effort can be all the more formidable if leases are entered into by individual segments, divisions, international subsidiaries or even at the project-level and are not consolidated at the parent level. In addition, locating these individually immaterial leases can extend to detailed searches within purchase card payments depending on the purchasing policies of an entity. An entity may also want to employ procedures like sampling and testing accounts payable disbursements to add an extra level of comfort that the lease population is materially complete.
Learn more about the process of reviewing leases in our ASC 842 lease accounting review template.
Lease Data Abstraction
If there is one step in ASC 842 implementation that earns the right to heightened attention from a company’s leadership, it would be the abstraction of data from lease agreements. ASC 842 brings with it enough technical complexities that a single lease agreement (and all subsequent amendments, renewals and modifications) may take a better part of a day or more to unravel and process. Minutiae like rent abatements, residual value guarantees, options to renew and/or terminate early, lease incentives like leasehold improvement allowances and other lease and non-lease components as defined by ASC 842 need to be abstracted and managed to properly calculate the initial lease liability and respective ROU asset to be recorded on the balance sheet.
Other required data points are needed that extend beyond lease agreements. For example, assessments to a lease asset’s fair market value, remaining economic life and other points of measurement are needed in order to differentiate between an operating lease and finance-type lease under ASC 842, which may impact EBITDA. This may be feasible with vehicle and equipment leases, but what about an office space in a multilevel building? Such information is to be provided by a company’s facilities team or real estate agent, which may also bring about unforeseen time and costs to the process.
Unsurprisingly, many companies do not have enough in-house resources to conduct lease abstraction efforts on their own and will seek assistance from a third party. This is where a good portion of the costs of ASC 842 implementation can balloon as billable hours can stack up quickly depending on the number of leases compounded by complexity of lease arrangements. Planning ahead and securing cooperation from other departments of the company providing input will translate to significant costs and, more importantly, time savings.
Discount Rate for Leases
To oversimplify ASC 842, lease liability is calculated as the present value of future lease payments. The discount rate used in the present value calculation is either the rate implicit in the lease or the company’s incremental borrowing rate.
ASC 842 defines the rate implicit in the lease as the following:
“The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor.”
As noted above, the rate implicit in the lease is for the most part lessor-derived and therefore requires the cooperation of the lessor, which may not come as easily as one might think, partially due to the sensitive nature of the variables.
The incremental borrowing rate is defined by ASC 842 as:
“The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment.”
For private companies, an accounting policy election makes things simpler by allowing the use of a risk-free rate for a period similar to the lease term. Without representative debt activity, a private entity would need the assistance of a financial institution to provide insights like comparable Moody’s or S&P credit ratings to determine which rate(s) to use. Depending on the company’s relationship with their banking partner, this service may result in additional one-time and ongoing costs to monitor credit worthiness.
Furthermore, if leases are originated and denominated in a foreign currency, the discount rate should reflect a borrowing rate reflective of the currency specified in the lease agreement. Further, a company may need to take into consideration economic and credit risks associated with the country/currency where the lease is executed when deriving an appropriate discount rate. For reference and additional research, refer to the following write-up on “Country Default Spreads and Risk Premiums,” which is maintained by a New York University professor.
Lease Accounting Solutions
Even if the lease population is limited, it may be worthwhile to engage a third-party lease accounting solution to calculate lease liabilities and ROU assets and respective monthly accounting journal entries as well as provide all necessary information for financial statements and footnote disclosures.
A myriad of lease accounting solutions in the marketplace offer a range of support – from accounting-only solutions that interface with existing lease administration software to complete suites that offer lease administration, space management and lease accounting and reporting. In determining which solution is the best fit, decision-makers will need to:
- Realistically assess available in-house resources to assist with implementation and data migration efforts, and
- Juxtapose that with a detailed understanding of the third-party implementation/migration process.
Many of the popular lease accounting solutions sub-contract “implementation partners” (e.g., Big Four accounting firms) to perform the implementation. It goes without saying that by being proactive and involved in the process, a company may be able to assume some or most of the detailed work and head off any foreseeable bottlenecks to reduce the number of billable hours invoiced.
One slight caveat: an ASC 842 subject matter expert should be available and intimately involved, be it an internal resource or third party to ensure strict adherence to the lease accounting standard.
For the private companies that have yet to tackle ASC 842 implementation and have been granted additional time to adopt the lease accounting standard, do not underestimate the time and resources required to successfully implement the lease accounting standard, and start as soon as practical.
The “lessons learned” above are but a few, albeit significant, steps in the process that can (and will!) inflate resources consumed and delay progress without proper planning and active project management. If implementing ASC 842 still appears too challenging to execute with available resources, 8020 Consulting has the experience and expertise to provide an effective targeted approach to implementing ASC 842 and providing continued support where and when needed. Contact us, or visit our financial reporting and accounting services page for more information.
Want More Insight?
Then stay tuned for part two, coming soon!
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About the Author
Kevin is an accounting and finance professional with nearly 20 years of experience. Kevin started his career in San Francisco in the audit and assurance service division of Deloitte serving major public and private clients spanning banking and finance, not-for-profit, manufacturing and hospitality industries. Subsequently, Kevin joined PG&E Corporation serving first in the regulatory accounting group and later as an accounting supervisor in the corporate reporting group. Kevin moved to Los Angeles and joined the Corporate Controllership team at The Walt Disney Company and enjoyed many successful years as a Senior Manager leading efforts pertaining to equity-based compensation and SEC and other external reporting for the Media, Theme Parks and Studio segments. Prior to joining 8020 Consulting, Kevin had previous consulting experience ranging from SEC reporting, process improvement, monthly close, forecast and budgeting, and project management at clients like Toyota Motor Credit Corporation and Southern California Edison. Kevin is a Certified Public Accountant and holds a Bachelor’s of Science degree in Accounting from the University of San Francisco.